Undertaking due diligence on the business is one of the most critical processes needed to eliminate risk when buying a business. Undertaking due diligence means thoroughly investigating what the seller has said about the business. It involves identifying the assets that are being sold and verifying that the seller owns, and is able to sell them.
The broad steps to undertaking due diligence are:
Step 1 - Information request
Request from the other party all of the information that you’d like to review. This information should include all material information regarding the company or the business that is being acquired. Some of the information that should be gathered includes:
- Corporate information: If you’re buying the shares in the company, you will need to obtain the corporate material relating to the company. This includes the history of the company, the constitutional documents and the company registers.
- Material agreements: You need to obtain all of the material agreements to review so you can determine whether there are any on going obligations following completion and whether there are any agreements which might impede the sale of the company or the business.
- Goods and services: Obtain the details of any material agreements relating to the goods and services so you can understand the obligations and whether there is any limitation to the ongoing manufacture, supply, storage and distribution of any goods or services after the sale completes.
- Lease: Obtain a copy of the lease for the premises, and any other licence or lease agreements relating to the assets. Check to determine whether you need to obtain the other party’s consent to assign the leases and licenses or whether you need to enter into new agreements.
- Financials: The financial information, including details of liability, loans, financial reports and statements help to establish the purchase price. Request for review the financials for the previous two or three years plus a list of debtors and creditors and forecasted budgets.
- Assets: In order to understand what the business owns, obtain a copy of the fixed asset register and all material agreements relating to the assets, and details of whether any of assets are secured in return for finance. If there are assets that are secured the security should be released before completion.
- Intellectual property: Intellectual property is usually a valuable asset of the business. Obtain the details of the intellectual property, including any trademarks, domain names, copyrights, business names and agreements relating to intellectual property.
- Litigation: Determine whether the business is subject to any litigation, whether current or contingent. Litigation is costly and might have an impact on the reputation of the business.
- Employees and contractors: Obtain the details and records of the employees and contractors and determine who will continue following completion of the transaction and whether new contracts need to be entered into.
- Customers and marketing: Obtain the details of customers and sales and cross check this information against the financials. Understand how potential customers are marketed to, including whether there is a marketing plan.
- Policies: To gain a better understanding of how the business is operated, review the policies and procedures of the business.
The above is some of the main items of information that you should obtain, however depending upon the business, other information will likely be required. The information will be facilitated manually or via a due diligence room, which is a portal where documents may be requested, uploaded and reviewed.
Step 2 - Review
The next step is to review all of the information received from the seller, or sourced via searches and market and industry reviews. There are four areas of review, including:
- Legal due diligence: The legal due diligence includes:
- Identifying all material information and documents concerning the business to determine the risks and whether any matter needs to be addressed prior, during or following the sale.
- Checking the contracts and the lease arrangements for their terms, identifying any onerous obligations, and ensuring that following the sale, you can obtain the benefit of them.
- Examining the business to identify any requirements that would prevent the transfer and change of ownership of the business.
- Identifying and verifying the ownership of the assets and determining the steps required to sell, assign or transfer the assets.
- Determining whether there are any associated risks with the assets, including any potential debt owing, breaches, litigation or failure to renew terms of any material agreements which might be essential for the business to continue operations.
- Financial due diligence: The financial due diligence includes:
- Double-checking the basis for the calculations in the financial statements which equate to the deemed value of the business.
- Verifying whether the sale price accurately reflects the value of the business.
- Determining the status of the assets and liabilities, creditors and debtors.
- Assisting with structuring the purchase price and the value attributed to the assets.
- Commercial due diligence: The commercial due diligence includes:
- Ascertaining whether the business has the documentation in place to reflect the commercial dealings.
- Whether there are sufficient assets to operate the business.
- Whether there are adequate supply arrangements in place.
- Industry and market due diligence: The industry and market due diligence includes:
- Checking the industry and understanding the risks in the business or industry that the business operates within.
- Undertaking market research. This process will provide you with a greater understanding of the target market, industry standards, the strengths and weaknesses of the business and whether there are any threats and opportunities.
Step 3 - Clarify
After reviewing the information that has been received, obtain clarification on any information that has been omitted or which is unclear. Sometimes the other party might provide further details readily upon request. Other times, the information might not be entirely clear, and extra insights about the business must be elicited.
Due diligence will form the basis of any further negotiation, the drafting of the sale agreement, and the inclusion of any warranties or indemnities. Due diligence must be completed before a binding contract is signed. If the sale contract is signed before the due diligence is complete, the binding agreement should be conditional upon the due diligence being completed to the buyer’s satisfaction. If you’re not happy with the results of the due diligence, even after asking for clarification from the seller, then if the agreement provided a condition that the results of the due diligence must be satisfactory to you, the transaction can terminate, or different terms may be arranged between the parties.
How much due diligence should I do?
Some people may consider that the business they’re buying is not worth much, so why bother spending the money on due diligence. If you take that approach, you might not be clear on the business that is being acquired, and many things can go wrong. You could rush into the transaction and underestimate the time required to transfer the assets, and not receive the title of all the assets. You may end up owing money under a contract because you didn’t review it.
In practice, how much due diligence you should do and the cost you’ll spend on the process will depend upon what’s practical and commercial. It’ll include taking into account the cost of the business and any perceived risks.
Key takeaways: Due Diligence
- Due diligence is an essential component of buying a business and includes legal, finance and market due diligence.
- It includes requesting the information that you need to review, reviewing the information and clarifying any information that has been omitted or needs further explanation.
- Due diligence enables you to investigate the business and the ownership of the assets, to determine risk and to qualify the processes that need to be fulfilled to fully acquire and receive the benefit of the business.
About the Author:
This extract has been taken from the book, ‘Entrepreneur Know How – Mindset and Winning Steps for Buying a Business,’ written by Sharon Robson (Available through Amazon). Sharon is also the principal lawyer, director and founder of the boutique law firm, Antler Legal – a corporate commercial legal practice in Sydney, Australia. She has played a key role in facilitating, advising and negotiating many business transactions on behalf of her clients. Sharon is also a speaker, marketer and business owner. She is passionate about mindset and empowering people through education.